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Information about Interest Only Loan

An interest-only loan is a loan in which for a set term the borrower pays only the interest on the principal balance, with the principal balance unchanged. At the end of the interest-only term the borrower may enter an interest-only mortgage, pay the principal, or (with some lenders) convert the loan to a principal and interest payment (or amortized) loan at his/her option.

US interest only mortgages

In the United States, a five or ten year interest-only period is typical. After this time, the principal balance is amortized for the remaining term. In other words, if a borrower had a thirty-year mortgage loan and the first ten years were interest only, at the end of the first ten years, the principal balance would be amortized for the remaining period of twenty years. The practical result is that the early payments (in the interest-only period) are substantially lower than the later payments. This gives the borrower more flexibility because he is not forced to make payments towards principal. Indeed, it also enables a borrower who expects to increase his salary substantially over the course of the loan to borrow more than he would have otherwise been able to afford, or investors to generate cashflow when they might not otherwise be able to. During the interest-only years of the mortgage, the loan balance will not decrease unless the borrower makes additional payments towards principal. Under a conventional amortizing mortgage, the portion of a payment that represents principal is very small in the early years (the same period of time that would be interest-only).

Interest-only loans represent a somewhat higher risk for lenders, and therefore are subject to a slightly higher interest rate. Combined with little or no down payment, the adjustable rate (ARM) variety of interest only mortgages are sometimes indicative of a buyer taking on too much risk- especially when that buyer is unlikely to qualify under more conservative loan structures.[1] Because a homeowner does not build any equity in an interest-only loan he may be adversely affected by prevailing market conditions at the time he is either ready to sell the house or refinance. He may find himself unable to afford the higher regularly amortized payments at the end of the interest only period, unable to refinance due to lack of equity, and unable to sell if demand for housing has weakened.

Due to the speculative aspects of relying on home appreciation which may or may not happen, many financial experts such as Suze Orman advise against interest-only loans for which a borrower would not otherwise qualify.[2]

UK interest only mortgages

Interest-only loans are popular ways of borrowing money to buy an asset that is unlikely to depreciate much and which can be sold at the end of the loan to repay the capital. For example, second homes, or properties bought for letting to others. In the United Kingdom in the 1980s and 1990s a popular way to buy a house was to combine an interest-only loan with an endowment policy, the combination being known as an endowment mortgage. Homeowners were told that the endowment policy would cover the mortgage and provide a lump sum in addition. Many of these endowment policies were poorly managed and failed to deliver the promised amounts, some of which did not even cover the cost of the mortgage. This mis-selling, combined with the poor stock market performance of the late 1990s, has resulted in endowment mortgages becoming unpopular.

The property boom from the late 1990s has seen house price inflation far outstrip wage growth. This has led to many lenders introducing a 'pure interest only' form of mortgage, one which needs no proof of a repayment vehicle. By August 2007, it was estimated that 29% of first time buyer loans were interest only leading to calls for caution from the mortgage sector. "Although interest only mortgages play a vital part in the mortgage industry, often providing the only means for first time buyers to hold the key to their own front door, misusing this type of loan is counter-productive," said Moneynet.co.uk chief executive Richard Brown.[3]

Canadian interest only mortgages

Some interest-only mortgages in Canada allow the borrower to pay interest-only, principal and interest, or even principal and interest plus 20% extra. An interest-only mortgage in Canada can be combined with corporate bonds in a Registered Retirement Savings Plan (RRSP) where the plan holder receives a tax deduction, tax deferral, and compound interest.

From an investor's perspective

Interest-only loans are sometimes generated artificially from structured securities, particularly CMOs. A pool of securities (typically mortgages) is created, and divided into tranches. The cashflows that are received from the underlying debts are spread through the tranches according to predefined rules, an Interest-only (IO) loan is one type of tranche that can be created, it is generally created in tandem with a principal only (PO) tranche. These tranches will cater to two particular types of investors, depending on whether the investors are trying to increase their current yield (which they can get from an IO), or trying to reduce their exposure to prepayments of the loans (which they can get from a PO).

Many homeowners saw the values of their homes increase by as much as 4 times its price in some markets in a 5 year span in the early 2000s. Interest-only loans helped homeowners afford more home and earn more appreciation during this time period. However, interest-only loans have contributed greatly to creating the current housing bubble situation, because many borrowers could not afford the fully indexed rate. Interest-only loans may turn out to be bad financial decisions if housing prices drop, causing those borrowers to carry a mortgage larger than the value of the house, which in turn will make it impossible to refinance the house into a fixed-rate mortgage.[4]

Calculating an interest only payment

Calculating an interest only payment is very simple when compared to calculating an amortizing payment. When calculating for a monthly interest only payment, one simply multiplies the monthly interest rate times the principal.

For example, the principal on a particular interest only loan is $10,000. The yearly interest rate is 6%. Therefore, the monthly interest rate is 0.5%. (6/12 = 0.5) To calculate the payment, multiply the .5% or .005 X 10,000 which results in a payment of $50.00. This payment is due each month. This seems like a steal, but when applied to the more typical numbers of a mortgage, such as a $200,000 mortgage at 8% yearly, the interest only payment would be $1,333.33 each month. Then, when you consider the payment on a mortgage with the same numbers amortizing over 30 years is $1,467.53, it doesn't look like the interest only loan is such a great deal because it will never be paid. Interest Only Calculator

See also

References

A loan is a type of debt. All material things can be lent but this article focuses exclusively on monetary loans. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the and the .
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Principal balance, in regards to a mortgage or other debt instrument, is the amount due and owing to satisfy the payoff of the underlying obligation.

Amortized mortgage loans automatically pay a portion of each monthly payment to the principal balance with the rest being
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For other uses of Amortization, see the Amortization disambiguation page.


Amortization is the distribution of a single lump-sum cash flow into many smaller cash flow installments, as determined by an amortization schedule.
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Amortization or amortisation is the process of decreasing or accounting for an amount over a period of time. Particular instances of the term include:
  • Amortization (business), the allocation of a lump sum amount to different time periods, particularly for loans and

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A mortgage loan is a loan secured by real property through the use of a mortgage (a legal instrument). However, the word mortgage alone, in everyday usage, is most often used to mean mortgage loan.
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Suze Orman (born Susan Lynn Orman on June 5, 1951[1]) is an American financial advisor, writer, and television personality.

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An endowment policy
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An endowment mortgage is a mortgage loan arranged on an interest-only basis where the capital is intended to be repaid by one or more (usually Low-Cost) endowment policies.
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A First time buyer (FTB) is a term used in the British property market, and in other countries, for a potential house buyer who has not previously owned a property.
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Property law
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A Registered Retirement Savings Plan or RRSP is an investment account that provides tax benefits for saving for retirement in Canada. RRSP refers to a provision in the Income Tax Act that allows a person to shelter financial property from taxes.
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Compound interest is the concept of adding accumulated interest back to the principal, so that interest is earned on interest from that moment on. The act of declaring interest to be principal is called compounding (i.e. interest is compounded).
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A collateralized mortgage obligation (CMO) is a financial debt vehicle that was first created in June 1983 by investment banks Salomon Brothers and First Boston. Legally, a CMO is a special purpose entity that is wholly separate from the institution(s) that create it.
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In structured finance, the word tranche (sometimes traunche) refers to one of several related securitized bonds offered as part of the same deal. The word tranche is French for slice; in the financial sense of the word, each bond is a slice of the deal's risk.
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An endowment policy
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This page gives descriptions of UK mortgage terminology which can often confuse borrowers.

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The UK mortgage market is one of the most innovative and competitive in the world.
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A balloon payment mortgage is a mortgage which does not fully amortize over the term of the note, thus leaving a balance due at maturity.[1] The final payment is called a balloon payment because of its large size.
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United States housing bubble is the economic bubble in many parts of the U.S. housing market that has existed since roughly 2001, especially in populous areas such as California, Florida, New York, the suburbs of Chicago and Detroit in the Midwest, the BosWash megalopolis, and the
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